The Debate between Inflation and Deflation

The money supply and many measures of monetary aggregates have increased in a dramatic way in the past couple of months. This increase has some people concerned about inflation and predicting a strong showing in gold. But the data show a real problem with the velocity of money. This change in velocity of money is significantly stronger than the change in money supply. The result will be a deflationary environment and gold and other commodities will not be good investments.

A quick review of basic Macro-Economics is in order. First, recall from Econ102 that the GDP equals the money supply times the velocity of money. Often the velocity of money is called the money multiplier. In a practical sense, if you have a $20 bill and spend it very fast and the retailer also spends it very fast, that one $20 bill can circulate to many times in one year. So that one $20 bill can be in say 100 transactions in a year. Or $20,000 of GDP is attributable to that one $20 bill. Now in our simple example we decide the economy is bad and we want to save that $20 bill. We put it in our wallet and don’t spend it for several months. Now that $20 bill may only be attributable to 10 transactions a year or $2,000 of GDP. If the US economy is not to drop from $20,000 to $2,000, then the money supply must increase. And increase in a dramatic way. Thus, GDP has to equal the money supply multiplied by the velocity of money. While this is a very simple example, it shows the point. If the velocity of money suddenly falls, then the money supply must increase or a large decrease in GDP will occur. After some math, the equation can be stated as: inflation is equal to the rate of money growth, plus the change in velocity, minus the rate of output growth.

In the past few months the money supply (M2) has increased. In the chart below notice the large increase in M2 in the past couple of months. So many are worried about inflation.


But this worry is misplaced and wrong at the present time. WHY? Because the velocity of money has crashed! For the first time since the Great Depression people dramatically decreased the pace they used money. This decrease in velocity is seen the in the following chart:



The velocity of money has fallen off a cliff! This is really important because of the multiplier effect. This means for GDP to stay constant, we need 50% more money, because in a very short time velocity has fallen 50%. This Money Multiplier chart shows that until the velocity of money increases, then the money supply needs to double NOW.

Going back to our simple formula, the money supply in one year has grown 9.5%, the velocity of money is -40.1%. This means that prices or output (YOY) must fall 31.4%! Even if output falls 10%, deflation would be 21.4%. The data for the velocity of money are STUNNING. The Federal Reserve is trying to increase the money supply in a dramatic way, but the concern is it will not be able to judge the correct amount of money to try to create. If the velocity of money numbers are correct, then they are not increasing the money supply at a fast enough pace to prevent a major deflationary period.

The concern of many that inflation may result will be true IF the velocity of money suddenly jumps back to it’s previous levels. But until the velocity of money increases, we will be in a DEFLATIONARY environment. Hard asset prices will fall and interest rates will stay low. At some point, inflation may explode, but NOT until the velocity of money returns to somewhere near it’s previous values.